Bailing Out the Betting Market

Here is a key bit from an article by Benjamin M. Friedman in the NY Review of Books. I've bolded key bits:

The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.

But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe—as would have happened if the government had not bailed out the insurance company AIG—the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise.

This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts—including not just banks but insurance companies like AIG—from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention.

Why has there been so little discussion of fundamental issues like this distinction among losses? Why is so little said about the trade-off between the goal of allocating the economy's capital efficiently and the need to shrink the enormous costs of the financial industry in doing so? One obvious reason is political. There is a long arc from Roosevelt's acceptance of a useful role for government institutions and government regulation to the conviction of Reagan and Thatcher that the government is never the solution but actually the problem. A second, closely related reason is ideological: the faith, personified by Alan Greenspan with his early dedication to the writings of Ayn Rand and his staunch opposition to regulations while chairman of the Federal Reserve, that private, profit-driven economic activity is self-regulating and, when necessary, self-correcting.

The above is, for me, the interesting bit. The rest of the article is a review of Robert Shiller's two books, The Subprime Solution and Animal Spirits.

I don't know how furiously Benjamin Friedman has been warning the world of the impending financial collapse, but in general the economists missed it. Sure Shiller made some noises and people like Nouriel Roubini has been crying doom. But, by and large, economists sided with Bernanke when in early 2007 he claimed that the subprime problem was "contained". Everybody expected maybe a mild recession but not the worst collapse since the Great Depression. This bothers me.

In engineering you occasionaly hear of a structure failing, a bridge falling down or a building collapsing, but rarely. Engineering is not a science but it is built on a science. Economics claims to be a science but doesn't deserve that title. It doesn't even support a decent engineering knowledge that would help keep the economy up or guide policy makers. Instead, economists remind me of the scholastic scholars of the Middle Ages arguing over the number of angels dancing on the head of a pin.

The foundations of their "science" is misplaced and absurdly "rational". Behavioural economists have some interesting results but no grand theories. They are a tiny neglected branch of economics. The senior positions, the positions with money and power are those that sell pixie dust and rational fantasies as a "science". This is truly sad. Consequently we have policies and regulations that are inadequate and wrong-headed. We have financial catastrophes. If I were an economist I would hand in my PhD and mutter my apologies as I shuffled off the academic stage and left the halls of power.